The Fed End Game

People are rightly outraged about the AIG bonuses [um, why not the Merrill Lynch ones that were far bigger and possibly involved outright fraud?] but the amounts involved in that are tiny compared to the size of our problems. I would agree that the bonuses themselves far outweigh their monetary value because they are reflective of an insular, entitlement mentality that has captured the Street and the Treasury Department. Until the culture has been broken we will continue to see a mess.

Anyway, forget all that for a second.

An hour ago the Fed announced it was buying another $750 billion in mortgage backed assets and will start purchasing long term treasuries, the first installment at $300 billion. In short, this is the long awaited “monetization of debt” that people have been expecting, or in other words, they are just printing money to simultaneously try to keep interest rates low and inflation expectations high (those are contradictory I’ll get to it in a second) with the hope that asset values will increase. Ben Bernanke gave a famous speech where he said deflation was impossible in a fiat system because they could just do a “helicopter drop” or in other words, print money. The idea was proposed by Milton Friedman as a way to avoid a depression.

This is potentially the start of the biggest gamble that the US government has taken with its currency since moving off specie and may have profound consequences for decades.

So the idea is that the treasury prints money, the Fed uses that to buy long term bonds to keep down interest rates and encourage investment, and then the money goes into circulation. Theoretically that money will cause inflation and — coupled with low interest rates — people will stop saving money and start buying stuff, getting out of the deflationary spiral and causing universal bliss. There are a few minor problems with this theory.

First of all, it’s a game of chicken. If inflation is going to rise then you don’t want to have bonds, so you’d sell them and cause the yields to rise. The more people that sell, the more the Fed has to buy to keep yields down, meaning the more money has to be printed, meaning the more inflation expectations will rise…etc. This can cause “embedded inflation expectations” which means that people will stop paying attention to reality and cause rampant inflation. This is what happened during the 70s, which ironically is what Friedman won the Nobel prize for, although the embedded inflation expectations in the 70s were due to an external resource shock rather than monetary policy per se. So then at some point the Fed has to stop and raise interest rates enormously to stop inflation expectations. If it does it too soon, well we’d still have a Depression (worse than not having the intervention) and if it does it too late, then our currency would be completely devalued against either other currencies or real goods (if all currencies are devaluing). When is that right time? Well no one has ever successfully used this, so no one knows. I’d argue that there is no right time because they operate on different timescales, and therefore it’s impossible to thread the needle…but their models say differently.

Secondly, if there is a lot of inflation, that needs to go out into wage inflation or else everyone without a lot of assets will just become a lot poorer. To say that our society doesn’t have the structure to have wage inflation take hold is putting it mildly. Also, as my post a few months ago mentioned inflation won’t inflate asset values evenly. Even if inflation takes hold, then housing still won’t increase much in value, but basic materials will skyrocket. It’s likely we’d have all the problems we have today but that it’d harder for most people to afford necessities. The banks still won’t lend very much because people are too indebted, but now the rich market makers will have lots of money so bubbles will form in lots of random asset classes.

In short, by trying to avoid a depression, they are punishing savers and rewarding debtors, and doing it in a way that makes the people that messed up have more wealth.

As the Wikipedia article on the Helicopter Drop states:

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries [in this case we can't because they have too much power] to give money directly to consumers or businesses [or large investors, which is what this is]. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away.

In essence it is a transfer of wealth far greater and more insidious than any tax increase and in the present environment will most likely be borne the most on the poor and middle class. As my friend succinctly put it after I described the theory (before stating my personal opinion): “so they are, in practice, devaluing all industry and commerce which hasn’t failed.”

There is a chance that they will start down this path and blink because it’s too big, and we’ll have a very fast Depression as they pull the plug and give up. This is literally the last tool they have and if it fails then there is nothing left. There is also a chance that they will continue to do the policy until inflation gets wildly out of control, threatening the security of the US dollar (especially if China decides to sell off its treasuries) or fiat currency in general (the UK started something similar and most countries will follow). This is why gold shot up a ton today. I think there is a small chance that it’ll work as intended, for the reasons I detailed in my series in the fall (here, here, here).

Don’t get me wrong, the steps that they have announced thus far are not large enough to really change things one way or the other. This is merely a $300 billion (well $1 trillion with mortgages) test balloon to try and influence people’s behavior. Of course this is like the 50th thing that they’ve done to manage expectations and those have all failed, and at this point people are being tricked for shorter and shorter periods of time, so the real question is what they will do over the course of the next year when the economy fails to pick up.

If you think we’ve seen a wild ride so far, just know that we ain’t seen nothing yet. This is going to make the moves in the bond and currency markets even worse, which will cause extreme volatility and lead to more failures. Even if the policy eventually works, it’s going to shake the system to the breaking point…whether it breaks and falls apart or rights itself at the last instant, I don’t really know; the entire environment is getting too ahistorical to try and predict. I for one am desperately hoping that people across the spectrum will wake up and start demanding policies that will preserve the integrity of the government, even though that means deflation and a depression. We can work through that, but it’s less clear how to work through the other.